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CAP RATE

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NOI

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CASH ON CASH

LTV

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IMPORTANT INVESTOR TERMS

As a person with an interest in real estate investing, you will likely be reading and/or listening to a lot of materials both online and offline.

The first thing you should know is that both real estate and investing are industries with plenty of their own specialized terms. Like any specialized subject, in order to understand them and have the best chance at success, it’s important to understand the basic words and concepts related to the subject.

Basic Real Estate Terms

Real Estate

It may seem odd that we would provide a definition for “real estate” but people don’t always have a full understanding of what real estate is. Real estate is land, any buildings on that land and any of the naturally occurring resources of that land, such as minerals, water, crops, wildlife, etc. It falls into three general categories: residential (homes, living spaces), commercial (retail stores, offices), and industrial (farms, factories, etc.)

Asset

Something you own which has value and from which you expect a future benefit. This can be in terms of both the actual value of the thing and its ability to produce more value. For instance, if you own a rental property, the property has a market value but also provides continual cash flow. Real estate, stocks and other investments are all assets. A business may increase its value by purchasing additional or newer equipment, premises, etc., thereby increasing its assets.

Equity

The meaning of the noun “equity” varies depending on the context in which it’s used. The most general sense of equity is “ownership.” How much of some asset (a house, a car, a stock) you own after all debts on that asset are handled? That’s your equity. For instance, a house has a market value of $350,000. If the owners owe $270,000 on it, then their equity (based on their mortgage payments so far) is $80,000. If they were to sell the house for the full market value, they would receive the $80,000 after the bank was paid what it was owed ($270,000). So, that’s the owner’s equity. If your car is paid off, it’s 100% your equity. If you own stock in a company that’s traded on a stock market, that stock is called “equity.” It’s how much of the company you own.

Liquidity

Refers to the relative ease with which an asset can be turned into cash, with little or no affect on its value. Precious metals such as gold are fairly liquid. If you own gold and it’s currently worth $600 an ounce, you can easily turn your ounce of gold into $600. A house, on the other hand, is not very liquid but is illiquid: not only is it more difficult to turn into cash quickly, but the price a buyer is willing to pay may be quite different (lower) than the house’s value on paper.  Liquidity is an important factor for investors because being able to quickly convert an investment to cash gives the ability take advantage of opportunities as they arise.

Income Property

Property that brings the owner income from tenant rent or lease is income property. Such properties can be residential or commercial and may be purchased or developed by the investor. One may also purchase income property, get cash flow from rent for a certain period and then sell the property when it appreciates sufficiently in value.

Flipping

Flipping is a real investment strategy which involves purchasing property with the intention of selling it quickly and at a profit. Sometimes, the profit comes from favorable market conditions, which increase a property’s value. It can also come from renovation or improvements that the “flipper” makes to the property.

Turnkey Property

An income property that an investor can purchase and experience immediate cash flow. A turnkey property is one that needs no repairs or renovation and which already has a renter in place. Turnkey properties are not necessarily in one’s own neighborhood, city or state. Landlord duties are usually handled by the management company rather than the investor.

Exit Strategy

This is the method by which an investor concludes an investment they made in the past, to get the benefit of that investment. Examples of exit strategies are the selling of a house one purchased and renovated or selling a stock or commodity once one is satisfied with an increase in its value.

 

Basic Investment Terms

1. Gross Scheduled Income (GSI)

GSI is the annual rental income a property would generate if 100% of all space were rented and all rents collected. If vacant units do exist at the time of your real estate analysis then include them at their reasonable market rent.

  • Rental Income (actual)

  • plus Vacant Units (at market rent)

  • = Gross Scheduled Income

 

2. Gross Operating Income (GOI)

GOI is gross scheduled income less vacancy and credit loss plus income derived from other sources such as coin-operated laundry facilities. Consider GOI as the amount of rental income the real estate investor actually collects to service the rental property.

  • Gross Scheduled Income

  • less Vacancy and Credit Loss

  • plus Other Income

  • = Gross Operating Income

 

3. Operating Expenses

Operating expenses include those costs associated with keeping a property operational and in service. These include property taxes, insurance, utilities, and routine maintenance. They do not include payments made for mortgages, capital expenditures or income taxes.

 

4. Net Operating Income (NOI)

NOI is a property's income after being reduced by vacancy and credit loss and all operating expenses. NOI is one of the most important calculations to any real estate investment because it represents the income stream that subsequently determines the property's market value – that is, the price a real estate investor is willing to pay for that income stream.

  • Gross Operating Income

  • less Operating Expenses

  • = Net Operating Income

 

5. Cash Flow Before Tax (CFBT)

CFBT is the number of dollars a property generates in a given year after all expenses but in turn still subject to the real estate investor's income tax liability.

  • Net Operating Income

  • less Debt Service

  • less Capital Expenditures

  • = Cash Flow Before Tax

 

6. Gross Rent Multiplier (GRM)

GRM is a simple method used by analysts to determine a rental income property's market value based upon its gross scheduled income. You would first calculate the GRM using the market value at which other properties sold, and then apply that GRM to determine the market value for your own property.

  • Market Value

  • ÷ Gross Scheduled Income

  • = Gross Rent Multiplier

Then,

  • Gross Scheduled Income

  • x Gross Rent Multiplier

  • = Market Value

 

7. Cap Rate

This popular return expresses the ratio between a rental property's value and its net operating income. The cap rate formula commonly serves two useful real estate investing purposes: To calculate a property's cap rate, or by transposing the formula, to calculate a property's reasonable estimate of value.

  • Net Operating Income

  • ÷ Market Value

  • = Cap Rate

Or,

  • Net Operating Income

  • ÷ Cap rate

  • = Market Value

 

8. Cash on Cash Return (CoC)

CoC is the ratio between a property's cash flow in a given year and the amount of initial capital investment required to make the acquisition (e.g., mortgage down payment and closing costs). Most investors usually look at cash-on-cash as it relates to cash flow before taxes during the first year of ownership.

  • Cash Flow Before Taxes

  • ÷ Initial Capital Investment

  • = Cash on Cash Return

 

9. Operating Expense Ratio (OER)

OER expresses the ratio (as a percentage) between a real estate investment's total operating expenses dollar amount to its gross operating income dollar amount.

  • Operating Expenses

  • ÷ Gross Operating Income

  • = Operating Expense Ratio

 

10. Debt Coverage Ratio (DCR)

DCR is a ratio that expresses the number of times annual net operating income exceeds debt service (i.e., total loan payment, including both principal and interest).

  • Net Operating Income

  • ÷ Debt Service

  • = Debt Coverage Ratio

DCR results:

  • Less than 1.0 - not enough NOI to cover the debt

  • Exactly 1.0 - just enough NOI to cover the debt

  • Greater than 1.0 - more than enough NOI to cover the debt

 

11. Break-Even Ratio (BER)

BER is a ratio some lenders calculate to gauge the proportion between the money going out to the money coming so they can estimate how vulnerable a property is to defaulting on its debt if rental income declines. BER reveals the percent of income consumed by the estimated expenses.

  • (Operating Expense + Debt Service)

  • ÷ Gross Operating Income

  • = Break-Even Ratio

BER results:

  • Less than 100% - expenses consuming less than available income

  • Greater than 100% - expenses consuming more than available income

 

12. Loan to Value (LTV)

LTV measures what percentage of a property's appraised value or selling price (whichever is less) is attributable to financing. A higher LTV benefits real estate investors with greater leverage, whereas lenders regard a higher LTV as a greater financial risk.

  • Loan Amount

  • ÷ Lesser of Appraised Value or Selling Price

  • = Loan to Value

 

Advanced Investment Terms

 

13. Annual Depreciation Allowance

Annual depreciation allowance is the amount of tax deduction allowed by the tax code that investment property owners may take each year until the entire depreciable asset is written off.

To calculate, you must first determine the depreciable basis by computing the portion of the asset allotted to improvements (land is not depreciable), and then amortizing that amount over the asset's useful life as specified in the tax code: Currently 27.5 years for residential property and 39 years for nonresidential.

  • Property Value

  • x Percent Allotted to Improvements

  • = Depreciable Basis

Then,

  • Depreciable Basis

  • ÷ Useful Life

  • = Annual Depreciation Allowance

 

14. Mid-Month Convention

This adjusts the depreciation allowance in whatever month the asset is placed into service and whatever month it is disposed. The current tax code only allows one-half of the depreciation normally allowed for these particular months.

For instance, if you buy in January, you will only get to write off 11.5 months of depreciation for that first year of ownership. Likewise, say you sell in January, then you will only get to writeoff half-month depreciation for that final year of ownership.

 

15. Taxable Income

Taxable income is the amount of revenue produced by a rental on which the owner must pay Federal income tax. Once calculated, that amount is multiplied by the investor's marginal tax rate (i.e., state and federal combined) to arrive at the owner's tax liability.

  • Net Operating Income

  • less Mortgage Interest

  • less Depreciation, Real Property

  • less Depreciation, Capital Additions

  • less Amortization, Points and Closing Costs

  • plus Interest Earned (e.g., property bank or mortgage escrow accounts)

  • = Taxable Income

Then,

  • Taxable Income

  • x Marginal Tax Rate

  • = Tax Liability

 

16. Cash Flow After Tax (CFAT)

CFAT is the amount of spendable cash that the real estate investor makes from the investment after satisfying all required tax obligations.

  • Cash Flow Before Tax

  • less Tax Liability

  • = Cash Flow After Tax

 

17. Time Value of Money

Time value of money is the underlying assumption that money, over time, will change value. It's an important element in real estate investing because it could suggest that the timing of receipts from the investment might be more important than the amount received.

 

18. Present Value (PV)

PV shows what a cash flow or series of cash flows available in the future is worth in today's dollars. PV is calculated by "discounting" future cash flows back in time using a given "discount rate".

 

19. Future Value (FV)

FV shows what a cash flow or series of cash flows will be worth at a specified time in the future. FV is calculated by "compounding" the original principal sum forward in time at a given "compound rate".

 

20. Net Present Value (NPV)

NPV shows the dollar amount difference between the present value of all future cash flows using a particular discount rate – your required rate of return – and the initial cash invested to purchase those cash flows.

  • Present Value of all Future Cash Flows

  • less Initial Cash Investment

  • = Net Present Value

NPV results:

  • Negative - the required return is not met

  • Zero - the required return is perfectly met

  • Positive - the required return is met with room to spare

 

21. Internal Rate of Return (IRR)

This popular model creates a single discount rate whereby all future cash flows can be discounted until they equal the investor's initial cash investment. In other words, when a series of all future cash flows is discounted at IRR that present value amount will equal the actual cash investment amount.

In a Nutshell

We know this all seems a bit overwhelming, but with these terms within your grasp, you can better understand your further reading on the topic of real estate investment and also speak more intelligently with people about the subject.  In the long run, what matters is How Much Can I Make on My Investment?

In other words, if I invest $10,000 and I get back $11,200 in less then a year what is my return on the money I invested?  The simple answer is you made $1,200 on a $10,000 investment or 12%, plus the return of your initial investment.  It's that simple.  Now you need the right property and the right partner.